Classical Trade Theories

Mercantilism

Mercantilism theory states that a country’s wealth is determined by the amount of gold and silver it holds. Thus to increase wealth, a country needed to discourage imports and encourage export to ensure that it always has a trade surplus in the form of gold and silver. Mercantilism formed the basis for protectionism, which is still relevant today. According to Valente and Lucas, even though this is one of the ancient theories, many nations still apply it while enacting protectionism, restrictions, and even home-based subsidy to allow local firms to compete and export more (120). However, its application is criticized as it is disadvantageous to taxpayers as other local firms are not protected. Additionally, when mercantilism policies are enacted, consumers obtain goods and services at higher prices from local manufacturers and foreign firms (Smridhi).

Absolute advantage principle

The absolute advantage principle was developed by Adam smith as a reaction to mercantilism. He argued that the government should not interfere with trade through protection and restrictions but should let trade be controlled by the forces of demand and supply (Wei-Bin 145). The theory is based on the idea that if country A can produce a good Y faster or cheaper (or both) than country B, then country A should specialize in producing good Y. On the other hand, if country B can produce good X faster or cheaper (or both) than country a, then country B should specialize in producing good X since it has an absolute advantage over country A (Smridhi). Through specialization, both labor and production would become efficient, and the country would benefit from economies, create wealth from the sale of goods, and improve the living standards of their citizens (Smridhi).

Comparative advantage principle

The comparative advantage principle was developed by David Ricardo to address the main shortcoming of the Absolute Advantage principle. He argued that a given country could have an absolute advantage in the production of more than one good while another country has no absolute advantage in producing a given product but can produce that product more efficiently than it does other products ( Valente and Lucas 137). Ricardo further argued that in such a case, countries could still specialize and trade with each other because each country will specialize in the production of goods in which they do relatively better. While comparative advantage pays attention to relative productivity differences, absolute advantage pays attention to absolute productivity (Wei-Bin 128).

Factor proportions theory and the Leontief paradox

Factor production theory states that countries should engage in producing and exporting goods that utilize the factors of production or resources that are in abundance and allow the importation of goods whose production requires the utilization of scarce resources (Smridhi). Wei-Bin notes that this theory was developed based on the argument that the cost of a factor of production is determined by its demand and supply (135). Hecksher and Ohlin developed this theory to help countries decide which product they had a comparative advantage in, something that the absolute advantage and comparative advantage principles failed to do (Wei-Bin 137). According to Valente and Lucas, the Leontief paradox emerged after research by Wassily W. Leontief about the US economy that indicated that despite the US having abundant capital, it heavily imported Capital intensive goods as opposed to exporting capital intensive goods in accordance with the proposals of Factor proportion theory (162). This was a clear indication that a single theory could not fully describe trade.

International product lifecycle theory

The product life cycle theory was developed by Raymond Vernon and states that a product passes through three stages in its lifecycle, namely: new product, maturing product, and standardized (Wei-Bin 138). It is based on the assumption that a new product is completely produced in the home country of its innovation. As a product moves from one stage to the other, its demand improves until the end of the third stage, when its demand in the home country diminishes, and another product is given attention. Its application was valuable in the 1950s and 1960s. However, its application today is limited because products are innovated in the home country, but their production may occur in different markets such as Asia and China, where there is plenty of highly skilled labor at considerably low cost (Smridhi).

New Trade Theory

New Trade theory is a model developed from various trade theories and focuses on returns to scale and network effects. It is based on the idea that today, most countries that engage in international trade have a lot in common in terms o structure, development, and resources. In contrast, old trade theories relied on differences in these factors from one country to another (Wei-Bin 154). It demonstrates that improvement in returns to scale drive trade today between countries since when they concentrate on certain industries or niche products, they gain economies of scale and benefit greatly (Smridhi).

Work Cited

Bretschger Lucas, and Simone Valente. “International trade and net investment: theory and evidence.” International Economics and Economic Policy 8.2 (2011): 197-224.

Duggal, Smridhi. “International Trade Law Theories”. Legalserviceindia.Com, 2021, https://www.legalserviceindia.com/legal/article-2758-international-trade-law-theories.html.

Zhang, Wei-Bin. “International trade theory.” Capital, knowledge, economic structure, money (2008).